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ARE THE NEW MEMBER STATES READY TO JOIN THE EURO AREA? A BUSINESS CYCLE PERSPECTIVE

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The present research employs a vector autoregression (VAR) approach to assess the degree of business cycle synchronization between the new member states (NMS), which have not adopted the single European currency, and the Euro area (EA). The main
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  72  Kalina Durova 1   Volume 28 (3), 2019 ARE THE NEW MEMBER STATES READY TO JOIN THE EURO AREA? A BUSINESS CYCLE PERSPECTIVE   The present research employs a vector autoregression (VAR) approach to assess the degree of business cycle synchronization between the new member states (NMS), which have not adopted the single European currency, and the Euro area (EA). The main fiscal and monetary factors affecting the business cycle coordination between the NMS and the EA have been identified. The causality between the business cycle convergence of the NMS and the EA and the implemented fiscal and monetary policies has been investigated in the short and in the long term. Recommendations and conclusions on the readiness of the NMS to join the EA have been made.  JEL: E32; E42; E50 Introduction In 2004, 2007 and 2013, thirteen new Member States (NMS) – Poland, the Czech Republic, Hungary, Slovakia, Slovenia, Lithuania, Latvia, Estonia, Malta, Cyprus, Bulgaria, Romania and Croatia, were admitted to the European Union (EU). Seven of these countries – Slovenia, Malta, Cyprus, Slovakia, Estonia, Latvia and Lithuania, have already joined the Euro area (EA). The rest six countries – Poland, the Czech Republic, Hungary, Romania, Bulgaria and Croatia, are also required to introduce the single European currency after meeting certain requirements (the Maastricht convergence criteria). Hence, the question is not whether, but when these six countries will become members of the EA. When assessing a country's readiness for a EA membership, it is advisable that not only the Maastricht convergence criteria but also the optimal currency area theory criteria be employed. The simultaneous use of the two groups of criteria contributes to combining their strengths, to avoiding their weaknesses and to obtaining a complete and credible assessment of the readiness of the Economic and Monetary Union (EMU) candidate countries. One of the most important criteria for a currency area's optimality is the similarity between the economic cycles of the participating countries. If these cycles are not synchronized, it is 1  Kalina Durova is assistant doctor at the Department of Finance and Accounting, Faculty of  Economics, South-West University „Neofit Rilski”, Blagoevgrad, phone: +359 87 9265574, e-mail: kalina_durova@swu.bg, kalina_durovaa_abv.bg.   – Economic Studies (Ikonomicheski Izsledvania), 28 (3), p. 72-95. 73 likely that the currency union will be affected by asymmetric shocks. Asymmetric shocks make common monetary policy ineffective and pro-cyclical in countries whose cycles are not converged with the aggregate cycle of the currency area. During an economic expansion, common monetary policy will create inflationary „bubbles” and danger of „overheating” the economy, and in a downturn will further exacerbate the recession in countries with divergent economic cycles. It is not recommended that countries whose individual business cycles are not sufficiently correlated with the aggregate currency area cycle join the currency union. One of the reasons for the debt crisis in the EA was the insufficient synchronization of economic cycles of peripheral countries with the aggregate currency union cycle. The objective of this research is to estimate the degree of readiness of Bulgaria, Romania, the Czech Republic, Poland, Hungary and Croatia for a EA membership from the standpoint of the convergence of their individual business cycles with the aggregate EA cycle. To achieve this goal, the study is structured as follows: •   Review and systematization of the theoretical and empirical studies on the coordination of the economic cycles of the NMS with the EA aggregate cycle (section one); •   Empirical estimation of the degree of convergence of the business cycles of Bulgaria, Romania, the Czech Republic, Poland, Hungary and Croatia with the aggregate EA cycle (section two); •   Identification of the fiscal and monetary factors influencing the convergence of each country's cycle with that of the EA (section three); •   Formulation of inferences and recommendations on the readiness of the NMS to join the EA (conclusion). In the present study, the methods of vector autoregression (VAR), Hodrick-Prescott filter, and formulation of inferences and recommendations on the readiness of the NMS to join the EA have been applied. Quarterly seasonally adjusted Eurostat data for the period from the first quarter of 2000 to the fourth quarter of 2017 have been used. All indicators have  been calculated as a percentage of real Gross Domestic Product (GDP), except for the output gap, which has been calculated as a percentage of potential GDP. Potential output has been estimated using a Hodrick-Prescott filter. The economic cycles of the NMS and the EA have been dated and their phases (expansions and contractions) and positions (inflationary and deflationary gaps) have been determined. The empirical evaluation of the degree of convergence of the economic cycles of the NMS and the EA has been carried out through three indicators: •   The percentage of coincident business cycle phases of the NMS and the EA; •   The percentage of coincident cyclical positions of the NMS and the EA; •   The correlations between the output gaps of the NMS and output gap of the EA. All variables have been tested for stationarity. If they had been found to be integrated of the first order, tests have been made for the optimal number of lags and co-integration of   Durova, K. (2019). Are the New Member States Ready to Join the Euro Area? A Business Cycle  Perspective. 74 Johansen. The optimal number of lags has been used in the Johansen co-integration test and later in the construction of the vector autoregression. If the Johansen test had demonstrated a co-integration connection between variables, a restricted VAR, also known as Vector Error Correction (VEC), has be applied. Otherwise, an unrestricted VAR has been used. The short-term cause-and-effect relationships between the variables have been analyzed via the Pairwise Granger Causality Tests, and long-term causal links through the Granger Causality / Block Exogeneity Wald Tests. Inferences and recommendations have been made on the readiness of the NMS to adopt the Euro. When selecting the explanatory fiscal and monetary variables for the vector autoregression, the specificities of macroeconomic policies under different exchange rate regimes and in a currency union have been taken into consideration. 1.   Review and systematization of the theoretical and empirical studies on the coordination of the economic cycles of the NMS with the EA aggregate cycle There are many studies on the coordination of economic cycles of the NMS with the aggregate EA cycle. According to Frankel and Rose (1998), patterns of international trade and international  business cycles are endogenous. Using data over a period of thirty years and twenty industrialized countries, Franklin and Rose inferred that countries with closer commercial ties had more coordinated economic cycles. Kutan and Yigit (2005) found evidence of the cyclical convergence of the new member states and the euro area. The authors concluded that the NMS managed to adapt to various shocks in the euro area. Brada et al. (2005) claimed that the NMS could adopt the euro quickly after joining the European Union (EU), but the benefits of such a step would have been limited. Fidrmuc and Korhonen (2006) made a meta-analysis of thirty-five publications on the synchronization of business cycles between the NMS and the EA. Some NMS have a high correlation of their cycles with that of the Euro area. The analytical methodologies have a significant impact on the results of the research. Zapodeanu (2012) concluded that the degree of synchronization of the business cycles  between the old Member States on the one hand and Slovenia, Slovakia, Cyprus and Estonia, on the other hand, had increased in the period 1995-2011, but the adoption of the euro had not affected it. Eickmeier and Breitung (2005) found that there was considerable heterogeneity among the  NMS, meaning that for some countries the EA membership would be more expensive than for others. Poland, Slovenia, Hungary and Estonia are more suitable candidates for EA than other NMS.   – Economic Studies (Ikonomicheski Izsledvania), 28 (3), p. 72-95. 75 Rinaldi-Larribe (2008) tried to determine whether there was a sufficiently high correlation  between the NMS and the EA business cycles, which would have been a reason for the  NMS to quickly adopt the euro. Stanisic (2013) concluded that there was a strong trend of convergence of the business cycles of the NMS with that of the Euro area. Dizdarevi ć  and Vol č  jak (2012) argued that the business cycles of most NMS were not synchronized with the EA cycle and that these countries could have experienced some difficulties if they had joined the euro too soon. Tomic and Demanuele (2017) concluded that Croatia's economic cycle was highly synchronized with the EA cycle. Todorov (2013) analyzed the nominal convergence of the NMS, their fulfillment of the optimum currency area criteria and the experience of the NMA who had already adopted the euro. Weimann (2003) inferred that the countries of Central and Eastern Europe (CEE) had a high degree of readiness for an EMU membership. Damyanov and Stefanov (2010) analyzed the level of synchronization of Bulgaria’s  business cycle with the EA cycle for the period 1995-2009. During 1995-2002 Bulgaria did not form an optimal currency area with none one of the EMU member states and probably suffered serious negative effects from the introduction of the currency board. In 2002-2009 the synchronization of the Bulgarian economic cycle with the cycle of the EA considerably increased compared to the period 1995-2002. Christos et al. (2007) found that all NMS had significantly increased the synchronization of their business cycles with that of the Euro area since the early 1990s. Carmignani (2005) concluded that the degree of synchronization of national business cycles with the Euro area business cycle was weak in all NMS, with the exception of Hungary and Poland. Matkowski and Prochniak (2004) inferred that the NMS converged with each other with the EA in terms of income levels and cyclical fluctuations. Daianu et al. (2017) identified problems in the NMS competitiveness in terms of infrastructure, institutional development and innovation. It is recommended that the NMS adopt the euro after reaching a minimum of 75% of the EA average per capita GDP and after carrying out a series of structural reforms. Van De Coevering (2003) concluded that structural convergence was progressing significantly more slowly than the nominal one and that the euro was not to be adopted  before a country had achieved a high degree of structural convergence with the EA. Frenkel and Nickel (2002) found that there were differences in the shocks and in the  process of adapting to them in the EA and in the NMS. According to Hallett and Richter (2012), there is a high degree of nominal convergence and a low degree of real convergence between the NMS and the EA, which causes a high   Durova, K. (2019). Are the New Member States Ready to Join the Euro Area? A Business Cycle  Perspective. 76 degree of synchronization of the short-term fluctuations and a low degree of synchronization of the long-term fluctuations of the economy. Darvas et al. (2005) found that fiscal convergence (the convergence of the fiscal balance to GDP ratio) increased the synchronization of business cycles among countries both within the EU and the EA. Rinaldi-Larribe (2008), Daianu et al. (2017), Eickmeier and Breitung (2005), Szeles and Marinescu (2010), Weimann (2003), Damyanov and Stefanov (2010) and Hallett and Richter (2012) argue that the euro should be adopted as soon as possible, while Brada, et al. (2005), Dizdarevi ć  and Vol č  jak (2012), Kontolemis and Ross (2005) and Van de Coevering (2003) claim that the NMS should not rush to enter EMU. Todorov (2012, 2013 and 2014) and Todorov and Patonov (2012) consider that the adoption of the single European currency should take into account the individual specificities of each country and the changes that occurred in the EMU as a result of the debt crisis. The reviewed studies may be classified according to different criteria – research methods, territorial scope, results, conclusions and recommendations. According to research methods, the literature reviewed may be separated into two large groups – theoretical and empirical studies. Rinaldi-Larribe (2008), Van De Coevering (2003) and Todorov (2013) may be included in the group of theoretical research. The investigations of Frankel and Rose (1998), Kutan and Yigit (2005), Fidrmuc and Korhonen (2006), Zapodeanu (2012), Stanisic (2013), Dizdarevi ć  and Vol č  jak (2012), Matkowski and Prochniak (2004), Tomi ć  and Demanuele (2017), Damyanov and Stefanov (2010), Christos et al. (2007), Darvas et al. (2005), Carmignani (2005), Daianu, et al. (2017), Frenkel and  Nickel (2002) and Hallett and Richter (2012) can be considered empirical. According to territorial scope, the reviewed research can be classified as studies on one country and studies on more than one country. The first group includes the investigations of Tomi ć  and Demanuele (2017) and Damyanov and Stefanov (2010). The authors, who analyze more than one country, are Frankel and Rose (1998), Kutan and Yigit (2005), Fidrmuc and Korhonen (2006), Zapodeanu (2012), Stanisic (2013), Dizdarevi ć  and Vol č  jak (2012), Matkowski and Prochniak (2004), Christos et al. (2007), Darvas et al. (2005), Carmignani (2005), Daianu, et al. (2017), Van de Coevering (2003), Frenkel and Nickel (2002) and Hallett and Richter (2012). According to their results, studies can be grouped into: •   Literature, which find a high degree of synchronization of the NMS business cycles with that of EA. Here are included Frankel and Rose (1998), Kutan and Yigit (2005), Fidrmuc and Korhonen (2006), Zapodeanu (2012), Stanisic (2013), Dizdarevi ć  and Vol č  jak (2012), Matkowski and Prochniak (2004), Tomi ć  and Demanuele (2017), Damyanov and Stefanov (2010), Christos et al. (2007) and Darvas et al. (2005); •   Research, which show a low degree of convergence of the economic cycles of the NMS with the aggregate cycle of the EA – Carmignani (2005), Daianu et al. (2017), Van de Coevering (2003), Frenkel and Nickel (2002) and Hallett and Richter (2012).

A Rounded Life

Oct 16, 2019
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